The iPhone Legacy: Pricier Smartphones?

Apple's cell phone has shaken up the wireless industry, which is racing to catch upwith new features and higher price tags

For a device that's been on the market all of four months, the iPhone certainly has had more than its share of impact.

Armed with slick software that gives it a dazzling interface and a touch-sensitive screen that's the envy of the wireless industry, Apple's (AAPL) first wireless device has set the bar higher for smartphones. Now rivals are rushing to meet the challenge. Phones that look like distant iPhone cousins—HTC's Touch, Nokia's N95, and the Venus and Voyager phones from LG—are hitting the market now or will soon.

And that can't help but nudge production costs upward, as manufacturers incorporate beefier software and more powerful and pricier chips. The race is on to add features while staying within price ranges consumers will accept. In turn, that trend is bound to depress sales growth, argues Richard Windsor, an analyst with Nomura Securities (NMR) in London.

Graphic Expectations

What a phone can do is at least as important, if not more important, than how a phone looks, and demand for fancier features will force companies such as Motorola (MOT), Nokia (NOK), Samsung, and LG Electronics to add additional chips. The most obvious example, Windsor says, is a dedicated graphics chip from companies like Nvidia (NVDA) and ATI (AMD), whose chips enable flashy graphics and features like those of the iPhone.

Graphics chips, Windsor argued in an Oct. 15 research report, could add as much as $10 to a smartphone's component costs, which would add several times that amount to the retail price. That's going to defy the long-term industry trend of cutting costs by shrinking chips and combining parts, and instead push prices upward as demand for new features rises. Windsor calls this "feature creep." "The growth in the addressable market has a lot to do with the speed at which you can reduce costs," Windsor says. "A lot of the cost reductions will be eaten up by feature creep. Apple raised everyone's expectations about what a smartphone needs to look like."

Those higher expectations will push the upper range of prices consumers are willing to pay, he says, which hasn't changed much historically. "What's the top-end Nokia phone cost right now? About €450 ($648). What did the top-end Nokia phone cost about five years ago? About €450," Windsor says. "The phone now can do 100 times more than the phone then could." Historically, he says, manufacturers have been able to squeeze out about 10% of the cost to build a device each year. But feature creep threatens to restore about 4% of those costs, according to Windsor's math.

More Memory Needed

Slowing growth rates for smartphones already are apparent. In 2005, Windsor says, consumers bought some 50 million smartphones, more than double the number purchased in 2004. In 2006, unit sales doubled again to north of 100 million units. In 2007, he reckons sales will hit about 144 million—still healthy growth, but nearly two-thirds off the preceding years' rates of growth. In 2008 and 2009, the rate of growth will slow even more, Windsor predicts.

David Carey, head of Portelligent, a consultancy that specializes in tearing down gadgets like wireless phones to estimate their materials costs, says the more likely cost driver in smartphones over time won't be graphics chips, but flash memory. "If you took all the memory out of an iPhone and compared its insides to a Nokia N95, you'd have roughly the same cost of components," he says "The component content that is most in demand is flash chips. If everyone starts chasing the iPhone, then the costs will go up, but that will be driven more by flash."

Indeed, smartphone makers already are boosting the amount of flash memory in their gadgets. Apple eliminated its 4-gigabyte iPhone, to offer just the 8GB version, and 8GB versions of Nokia's N95 and N81 are expected this week. Within a year these same phones could be sporting 16GB, Carey says.

Maybe Just One Chip Will Do

But will the higher costs actually translate to slower growth? Jagdish Rebello of iSuppli, a Silicon Valley-based market research firm, doesn't think so. Instead he expects the market to break down into segments. "When the handset market is a billion units a year, there's enough room for the manufacturers to differentiate themselves. And that will put pressure on the semiconductor companies to do more differentiating of their own."

Chip companies, eager to boost their silicon share inside each phone, are combining chips at a blistering pace. "We've got products on the market now that not only combine two or three chips into one, but can integrate eight or nine different kinds of chips into one," says Yossi Cohen, vice-president and general manager of the wireless chip unit at Broadcom (BRCM). In practice that should keep costs under control. Like Carey, he thinks the demand for more features will lead to more software, which will require more memory. "If mobile phones become more like computers, they're going to need a lot more memory to store all those downloadable applications," Cohen says.

There's also a case to be made for doing more with the chips already available. Avner Goren, who heads marketing for the wireless chip business at Texas Instruments (TXN), contends there's no real need for smartphones to have graphics chips. "The effects that make a sexy interface are taking advantage of graphics hardware that is already embedded in the chips," Goren says. "The hardware to do it is already there."

It's clear, however, that the release of the iPhone has increased the sense of urgency for Apple's rivals. In its first 90 days on the market, Apple sold 1.4 million iPhones, or about 15,000 per day. The company is readying launches in Britain, France, and Germany later this month. Then there's the possibility that a more sophisticated iPhone will hit the market sometime in 2008. (Apple hasn't said when the next iPhone will be released.) Apple's phone set a new bar not only for performance, but also features. And that, says Windsor, means "everyone else is going to have to keep up, and that is going to keep costs trickling upwards."

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